subject: The Relaxing Retirement Equation: Determine Your Required Rate of Return [print this page] The Relaxing Retirement Equation: Determine Your Required Rate of Return
Over the last few weeks, I've exposed you to the first steps in The Relaxing Retirement Equation which were all developed to help you determine your level of dependence on your Retirement Bucket (the investments you've built up over your lifetime) by getting crystal clear on all of your income sources, and what it costs you to support the exact lifestyle you want.This is THE biggest distinction between investing during your working years and your retirement years, and it's the point that I will continue to help you focus on.Every "retirement calculator" discussion or article I read begins with you assuming the investment rate of return you either want or think you can earn.This completely puts the cart before the horse, and it's what gets so many people into trouble.Instead, once you know how dependent you are on your Retirement Bucket, the next question is, "what investment rate of return do I need to earn to make it work?"That rate isn't chosen arbitrarily. It's the rate of return that allows your money to keep pace with inflation and remain intact year after year while allowing you to continue to spend what you want.ConsequencesWhen you've reached the stage where the money you've saved must now support you for the rest of your life, when you are dependent on your money to "live" as opposed to receiving a paycheck from the work you do, you have to think very differently about how you're investing your money.This is no longer a game. It's no longer a race. You can't afford to lose this time because, if you do, you'll be forced to do one of two things: make drastic cutbacks in your lifestyle (who wants to do that after working all these years in preparation for this stage in your life where you get to reap all the rewards of being a diligent saver), or you will have to go back to work to make up for the losses, something your health could prevent you from doing in the future. Neither of those sound like very good outcomes, so that's why you have to think very differently about investing at your stage in life.And, it's why you have to know the rate of return you must earn, as opposed to randomly investing your money in whatever appears to be the 'hot' thing at the momentHow Do You Determine Your "Rate"?The investment rate of return you must earn is dependent on three things: Your Level of Dependence: how much money you need to withdraw from your Retirement Bucket (your investments) each year to supplement your social security and pensions, The Size of your Retirement Bucket: the amount of money you've accumulated over your lifetime to draw from to provide this supplemental income, and Inflation The good news for you is that I've outlined how you can determine your level of dependence using Relaxing Retirement Equation steps one and two over the last few weeks.Have you done your homework? If not, I urge you to delve into it. This is too important to get lazy with.Calculating the size of our Retirement Bucket comes down to you having accurate and up-to-date statements on all of your bank and investment accounts. Given that we're at the beginning of a new year, you should be able to put your hands on December 31, 2010 statements rather easily.That brings us to #3. When it comes to inflation, you have to make some assumptions as to what you believe the rate of inflation will be in the future. Without going into too much detail on that issue here (I've gone into great depth about my opinion on inflation in a prior Strategy and will do so in the future), I strongly recommend that you assume a higher rate of inflation than the present to be conservative. Hint: a 3% assumption is very aggressive.Getting back to Steps One and Two, once you know your level of dependence, i.e. the amount of money you need to withdraw from your investments each year to keep pace with inflation, and you know the amount of money you've accumulated in your Retirement Bucket, the investment rate of return you "need" to earn is the rate that allows your money to remain intact year after year while allowing you to continue to spend what you want.Why You Must Know ThisIf you have a large Retirement Bucket, and you only need to withdraw a little bit each year for your supplemental income needs (like Doug and Diane in our story over the last few weeks), you probably don't need a very big investment rate of return.On the other hand, if you need to withdraw a lot of money each year from your Retirement Bucket, like Gary and Grace, you may need to earn a much greater rate of return.Either way, the key is knowing that rate because if you don't, you may very well be investing more aggressively than you need to and subjecting yourself to far too much volatility, risk, and potential loss. (Think of the devastating market crashes of 2002 and 2008!)And, at the same time, if you don't know the rate you need, you may be investing too conservatively and run out of money because your money isn't growing fast enough to keep up with your spending needs.The Medical AnalogyTo draw an analogy, it would be like you taking a new medication without a doctor first analyzing your symptoms and doing a thorough examination to determine if you even need any medication at all.When asked why you're about to take this new potent drug, the doctor tells you that it's a really popular drug right now. It's all over the news and everyone's taking it.Now, if that sounds ridiculous to you, you're right. However, this is how millions of Americans select their investments in retirement.They don't have a carefully calculated rate of return they're aiming for. And, because they don't, they're at the mercy of the next salesperson who sells them whatever makes that salesperson the most money, or whatever appears to be "hot".For all the reasons I mentioned above, this is extremely dangerous. Don't be lazy and fall into this trap. Take the time to determine the investment rate of return you need to earn first.Then you can go about crafting an investment matrix and specific investments that have the highest likelihood of getting you that rate of return over the long run.
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